If the US exceeds the debt limit, here’s what the Fed will do
It’s this time again: the suspension of the national debt limit is ready to expire July 31. If Congress and the President don’t increase or resuspend that cap, they will force the US Treasury to default. The Federal Reserve predicted such a crisis: If the dollar defaults, break the glass. I know their playbook. I will read you using their own words.
Let’s be clear: the risk of the dollar defaulting is low. As Secretary of the Treasury Janet Yellen
mentionned in 2011, when she was vice chairman of the Federal Reserve, the debt limit “usually turns out to be just a theater”, although “there is more capacity for mischief here than usual”. She was right. That year, President Barack Obama and Republicans in Congress put the country on the phone. Barely avoiding default, the US government received its first credit downgrade. In the aftermath of the crisis, Jerome Powell, now chairman of the Fed, I described it as a “self-inflicted injury”.
Today, in the absence of a filibuster-proof Senate majority, Democrats cannot take power by resuspending an online vote. Assuming Democrats don’t use parliamentary judo, they’ll soon run up against Republicans on the budget again.
Each time, the Fed is caught in the middle. In April 2011, Brian Sack, then manager of his securities portfolio, described the likely consequences: “A higher risk premium on the Treasury curve, a weaker dollar and downward pressure on US asset prices.” In June 2011, he also described the likelihood consequences on financial markets: loss of liquidity and greater volatility in the Treasury market, bleeding into the wider financial system. In particular, yields would increase for Treasury securities at risk of default. Conversely, as the Treasury repays debt and depletes cash, repo rates could be pushed down as the supply of collateral declines and reserve balances increase.
At an October 2013 meeting, Fed policymakers discussed plan how to respond. They had not revised these plans as of December 2015, the last meeting for which transcripts are currently available. What about the intervening years? I led the New York Fed’s forecast in the fight against the 2019 debt limit, the one that created the two-year deal that will expire. After advising policymakers on these issues, trust me: the Fed has too much work to do to fix what didn’t break.
Here is this playbook:
First, the Fed made payment plans, presented by Senior Deputy Director Susan Foley. On instructions from the Treasury, Fed staff will defer the scheduled payment of principal and interest in one-day increments. Although still in default, this intervention will allow the continuation of trading in these securities between market players, including in Fed operations. Regarding the other payments: “Each evening, the Treasury will make the decision to release or delay the payments according to the [cash] balance projections for the next day. It is important to note that “payments made will be settled as usual, and financial institutions and consumers need to be confident that payments made will not be canceled.”
Next, policymakers drew up plans for the supervision and regulation of banks, under the leadership of Director Michael Gibson. The Fed will treat defaulting Treasury bonds the same as non-defaulting bonds. Their regulatory treatment will remain the same, including their risk weightings of capital requirements. In addition, these titles “will not be rated negatively or criticized by reviewers”. He recognized the possibility of a temporary decline in capital ratios due to growth in the balance sheet and for borrowers to experience temporary financial hardship. In each case, supervisors would work with the bank to determine whether it was “still in fundamentally sound condition” despite the “temporary decline in its regulatory capital”.
The Fed has also developed monetary policy plans, presented by Secretary Bill English. A default would “have significant consequences for monetary policy and the Fed’s financial stability objectives.” Even so, policymakers “presumably want to avoid the impression that the Federal Reserve was actually funding government spending.” The Fed should avoid “the subjugation of our monetary policy objectives to the financing needs of the Treasury,” as Richmond Fed Chairman Jeffrey Lacker put it.
English described three groups of options.
The first allows the Fed to transact in defaulted Treasury bonds at market prices, “as long as it appears certain that the deferred interest and principal payments will be made in full and within a relatively short period of time.” . The securities would be eligible for “outright purchases, securities lending, rollovers, repurchases to keep the fed funds rate within its target range and discount window loans.”
The second group of options eases tensions in the money markets. Policymakers could ask the New York Fed to conduct reverse repurchase transactions in order to “provide the market with a flawless Treasury guarantee.” By providing collateral and reducing reserves, these operations would ease the pressure of negative repo rates. Likewise, policymakers could ask the New York Fed to enter into repurchase agreements to alleviate the higher rates resulting from market failure.
Third, after exhausting its previous options, the Fed could move the defaulted securities to its balance sheet using targeted purchases or swaps. By far, this set of options is the most controversial. Powell described them as “disgusting” but would be prepared to accept them “under certain circumstances”. His reluctance? “The institutional risk would be enormous. The economy is fair, but you would step into this difficult political world and look like you made the problem go away. Lacker called it “beyond the pale”. John Williams, then chairman of the San Francisco Fed and now at the New York Fed, supported keeping these options on the table. “Apparently I’m beyond pale,” he joked.
There appears to be broad support for the first and second option groups. Despite significant reservations, no governor or Fed chairman has categorically rejected the third group.
As it stands, all options are on the table and the stakes have never been higher. My message to Washington is simple: don’t force the Fed to use any of them. Yes, despite the serious institutional risks recognized by all, the Fed will try to mitigate the “serious threat” of a dollar default. But with each unprecedented intervention, they weaken their credibility and reinforce moral hazard. One day, they will no longer be able to come to your rescue.
Christopher M. Russo is a research fellow at the Mercatus Center at George Mason University. Prior to joining Mercatus, he advised Federal Reserve policy makers on monetary policy and sovereign debt management.